Don’t count your chickens

Take reports of changed pension deficits with large amounts of salt. It’s always important to put news in context, and to think about what’s going on underneath, especially when you read a story based on a survey or report produced by a consultant. And yes, I am a consultant, and that applies to surveys or reports I put out, too.

In yesterday’s FT there was a piece (£) about the pensions funding position. Apparently it hasn’t changed much since December 2010,

partly because the gap between yields on government bonds and those on corporate bonds has widened, which has the effect of reducing liabilities.

No it doesn’t. Absolutely not. The liabilities have not changed an iota because of any change in bond yields. The pension schemes are still on the line for the same payments in the future as they were. The only thing that has changed is one estimate of the present value of the liabilities, in other words how much money should be set aside now to pay the liabilities in the future.

But let’s get this straight. Nobody knows how much the pension schemes will have to pay out in the future. It depends on all sorts of things — including how long the pensioners live, what survivors they leave when they die, what future inflation rates are, whether members of the scheme transfer out before starting to draw their pension, what options they exercise when they do start, and countless others. And that’s without even considering what can happen to active members (those still in employment). So the actual payments out are uncertain.

And the payments in are uncertain too — investment returns, employer contributions, member contributions.

It’s fairly easy, nowadays, to estimate the value of the assets — just use the market value. Which is of course highly volatile, especially in the short to medium term.

It’s much less easy to estimate the value of the liabilities. You project the likely future payments, and then use a discount rate to come up with a present value. Which could be volatile too, as well as uncertain, if the discount rate you use is volatile.

So the deficit (or surplus) is the difference between two large numbers, at least one of which is highly volatile and the other is highly uncertain. No change that occurs over just a few months can be really significant, if nothing else has changed.

Just apply some common sense. If the assets are the same assets (no big changes in investments), and the liabilities are the same liabilities (no big changes in membership or benefits), then the long term position simply can’t have changed significantly. Pensions is a long term business. Transient changes in estimated current values are bound to happen, but in the end what matters is that the benefits are paid out when they fall due.

1 comment

I have never before been one to defend the Financial Times’ analysis of company pensions, but I’ve been spending a lot of time lately with actuaries, helping them with their communications, so I hope you won’t mind if I delve into one of your observations and ask what non-actuaries might make of it. (And, indeed, what actuaries should properly make of it.)

In your third paragraph, you try to distinguish between “liabilities” and the “present value of those liabilities”. You wrote:

“The liabilities have not changed an iota because of any change in bond yields. The pension schemes are still on the line for the same payments in the future as they were. The only thing that has changed is one estimate of the present value of the liabilities, in other words how much money should be set aside now to pay the liabilities in the future.” [Emphasis added]

I have two challenges for you. The first is that the distinction is an artificial one which would not be recognised by the man or woman on the street (or the finance director in their sumptuous office). The second challenge is that the FT wasn’t writing about the pension scheme’s liability. The FT was writing about the company’s liability – and the company’s liability has, indeed, reduced.

Take the second point first. The company’s liability is to ensure that the scheme is funded up to its technical provisions (or have a recovery plan in place to achieve that). Changes in yields lead to a change in the technical provisions and hence a change in the company’s liability. To the finance director, this is a very important distinction.

But, even without this distinction between the scheme and the company, I would still invite you to reconsider your point. In practical terms, an entity doesn’t just have a liability to pay money out on a series of future dates; the entity has some form of legal obligation (which varies depending on its legal status) to raise the funds to meet that liability. If yields go up, currently held assets can be invested at a greater return and the amount of additional assets which need to be raised is reduced.

In short, the concept of a liability “to pay £P at time T” is an incomplete one, other than in theory. In practice, there is (normally) a liability to put oneself in a position to be able to pay £P at time T. Higher yields between now and time T will normally make that liability less burdensome.